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Investors looking to generate a steady stream of income are faced with lots of options, from a simple CD to different flavors of annuities, individual bonds, or professionally managed portfolios. Another popular option is a bond ladder. Like all these options bond ladders have their advantages and disadvantages, but many investors decide to build one because it can help manage the risks of changing interest rates and produce predictable income.

If you do decide to use a bond ladder, Fidelity has some ideas we think you may want to consider about how to build one. “While not for everyone, bond ladders can be an effective way to invest for income by creating a predictable income stream,” says Richard Carter, vice president of fixed-income securities in Fidelity’s brokerage division.

A bond ladder is a portfolio of bonds that mature at regular intervals. These intervals are the “rungs” of the ladder. For example, a simple bond ladder could contain five rungs of roughly equal value that mature in two, four, six, eight, and 10 years, respectively. In two years, when the first bonds mature, you have a choice. You can take your money out of the ladder—to spend or invest elsewhere—or you can reinvest the principal in a new 10-year bond—adding a rung to the ladder. Two years later you can do the same with the next bond to mature. With this structure a bond will mature periodically, returning your investing principal. If you choose to reinvest, you can continue the ladder indefinitely.

Managing reinvestment risk

Interest payments from the bonds in a ladder can provide predictable cash flow. In addition, the ladder can help you manage reinvestment risk. To illustrate, say you invested all your fixed-income allocation in a single bond. That bond eventually would mature, the issuer would return your principal, and you’d have to purchase a new bond if you wanted to continue generating income or maintain your portfolio’s asset allocation mix. But if interest rates and bond yields had decreased in the meantime, you wouldn’t be able to generate as much income as before with the same amount invested—at least not without taking on additional investment risk. That’s a predicament some investors who rely on investment income won’t want to find themselves in.

Diversifying among numerous bonds that mature at different intervals, in a ladder, has the potential to decrease this reinvestment risk. Imagine that yields fall before you purchase a new bond: Now, you’ll have to reinvest only a fraction of your portfolio at the lower rate, so the impact may be smaller when rates fall. (The greater the number of bonds with different maturities—that is, the more “rungs” on your ladder—the smaller the impact may be, provided the period of declining rates is not too long.) Meanwhile, the other bonds in the portfolio will continue generating income at the relatively higher older rates.

What if yields and interest rates increase? A ladder may provide an advantage in this case as well. If you had invested all your money in a single bond, you’d miss out on the new, higher rates until it matured. By contrast, a bond ladder continually frees up a slice of your portfolio, so you can take advantage of the new, higher rates.

“A bond ladder gives you a framework in which to balance the flexibility of short-term bonds with the potentially higher yields that longer-term bonds typically offer” says Carter. “In that way, ladders may also be a way to protect ourselves from the emotional swings of investing, because the short-term bonds typically have lower duration and lower price volatility than long-term bonds.”

Having a well-diversified bond ladder does not guarantee you will avoid a loss, but it can help protect you the way that any diversified portfolio does, by helping to manage the risk of any single investment. If a bond issuer defaults, investors can lose their entire principal—that could be a significant event. Spreading your assets among numerous securities may limit the impact if any single security performs poorly. For example, say your bond ladder is composed of corporate bonds, and one of the companies defaults on its obligation: It could still be a serious loss, but you’ll have other bonds, so only a portion of your portfolio may be impacted by the bond’s default.

Bond ladder considerations

While building a bond ladder allows you to protect yourself from interest rate and reinvestment risk, there are some important guidelines to consider to make sure you are diversified and to attempt to protect yourself from undue credit risk.

Holding bonds until they reach maturity.
It’s important that you have enough money set aside to meet your short-term needs and deal with emergencies. You should also have a temperament that will allow you to ride out the ups and downs of the market. That’s because many of the benefits of bond ladders—such as a predictable income plan and managing interest-rate and credit risk—are based on the idea that you keep your bonds in your portfolio until they mature. If you sell early—either because you need cash or you change your investment plans—you will be exposed to additional risks.

Starting with at least $100,000.*
This isn’t a hard-and-fast rule, but because bonds generally must be purchased in minimum denominations (often $1,000), $100,000 or more is often required to achieve a degree of diversification across a broad range of different issuers in different sectors. In fact, you may need to start with a larger investment, depending on the types of bonds you wish to hold. The reason: The lower the credit rating of the bonds in a ladder, the greater the number of bonds that may be required to diversify against the risk of default. For example, with a ladder composed of corporate bonds, you may want to consider a minimum investment of at least $200,000. If you can’t invest enough to diversify, you may want to look at other income options, like diversified bond mutual funds or annuities.

The following table offers some suggestions on how many different issuers may be required to help achieve diversification at different credit ratings.

How many issuers might you need to manage the risk of default?

Please note: Investors may want to consider other diversification factors including industry and geography.

Building your ladder with high-credit-quality bonds.
Bond ladders are intended to provide consistent income over a long period of time, with minimum ongoing research and vigilance. If you are adequately diversified among issuers, the default of a single bond within your ladder should have a limited impact on your cash flow. After all, you can replace a rung in the event of a default. But you may not be able to replace a bond with another that has identical features—your choices are limited to what bonds are available when you make the purchase.

The bonds in a ladder are held until maturity, so price declines caused by rating downgrades generally won’t affect the income stream. But investors need to remember that bonds can go through more than one downgrade in rapid succession, heightening the market’s perception of default risk. “It is true that even a BBB-rated bond is considered several steps away from default,” notes Carter. “But the probability of further downgrades and ultimately default increases with each downgrade.

How do bond ratings work?

Two of the major independent credit rating services are Moody's and Standard & Poor's. They research the financial health of each bond issuer (including issuers of municipal bonds) and assign ratings to the bonds being offered. A bond's rating helps you assess that bond's credit quality compared to other bonds.

Another consideration when selecting securities for your portfolio is transaction costs. Typically, the total cost of a lower-quality bond may be higher than the total cost of a higher-quality bond after you factor in trading costs and market pricing. These costs could be especially important if you plan to reinvest your principal as the bonds in your ladder mature—those additional transactions would create more costs.

Since the purpose of a bond ladder is to provide consistent income over a long period of time, taking excessive amounts of risk probably doesn’t make sense. So we strongly encourage considering only more highly rated bonds, such as A-rated bonds or better.

Avoiding the highest-yielding bonds at any given credit rating.
When selecting individual bonds for your ladder, you’ll have a choice of numerous bonds with a range of yields at the credit rating level you’ve chosen. You may feel inclined to choose the highest-yielding bonds in that group, figuring they represent a bargain—more yield for the same amount of risk.

Resist that temptation. An unusually high yield relative to other bonds with the same rating is often an indication that the market is anticipating a downgrade or perceives that bond to have more risk than the others and therefore has traded the bond’s price down (thereby increasing its yield). That can happen in advance of an official downgrade. The rating agencies frequently lag behind the market, and often don’t even reinvestigate an issuer until after the market sends up a red flag.

Fidelity’s Bond Ladder tool allows you to select Low, Medium, or High Yield at any given credit rating setting, and lets you screen bonds according to your preferences. Consider choosing the Medium Yield or the Low Yield setting, which would screen out unusually high yields relative to other bonds with the same rating.

Watching out for callable bonds in your ladder.
When a bond is called prior to maturity, its interest payments cease and the principal is returned as of the call date. If you seek to reinvest this principal in a similar bond issue, you may have to accept a lower yield (and lower interest payments) depending on prevailing interest rates. A called bond will alter both your cash flow schedule and the schedule of principal coming due.

Moreover, several bonds might be called within short succession of each other. Market conditions that cause one bond to be called might cause other bonds to be called as well—only exacerbating the cash flow and reinvestment challenges.

Our Bond Ladder tool provides the option of including or excluding callable bonds in your ladder. The default setting on the tool includes “Call Protection,” which excludes bonds that have typical issuer-option call provisions.

Thinking about time and frequency.
Another important feature of a bond ladder is the total length of time the ladder will cover and the number of “rungs,” or how often the bonds in the ladder are scheduled to mature, returning your principal. The more rungs you have, the greater your diversity of maturities, and the more opportunity and exposure to future interest rates.

Hypothetical example using Fidelity’s Bond Ladder tool

Over a period of 15 years, Joe Smith built a small but healthy technology company that produces enterprise software for law firms and other professional offices. In 2010, a couple months after his 50th birthday, Smith was approached by a competitor with a buyout offer and, after some negotiations, sold his company for around $1 million. He hoped to use the proceeds of the buyout to produce a stream of income using a bond ladder until he reached retirement, in about 15 years.

Joe considered a ladder with 14 “rungs” of about $70,000 each. In order to be broadly diversified, the rungs each contained a range of bonds and FDIC-insured CDs at different credit rating levels.

For illustration only. Source: Fidelity.com.

For illustration only. Source: Fidelity.com.

Note that the tool enables investors to begin with their total investment amount—or to back into the total investment amount required to help achieve a desired level of annual income. Smith chose the former. On this screen, he also chose to build his ladder from a variety of Treasury bonds, CDs, government agency bonds, and corporate bonds.

For illustration only. Source: Fidelity.com.

For illustration only. Source: Fidelity.com.

Here, Smith chose to limit his ladder to bonds that receive a minimum rating of Aa or better. He also chose the “Lowest Yield” setting in order to reduce the risk of buying a bond that is priced away from others on the same yield curve, a possible indication the market expects it might be downgraded in the near future.

For illustration only. Source: Fidelity.com.

For illustration only. Source: Fidelity.com.

This is where Smith determined the "height" of his ladder (15 years), the number of “rungs” it would have (14), and whether or not it could contain callable bonds (he excluded callables).

For illustration only. Source: Fidelity.com. For bond ladders, the principal gain/loss is the difference between the Total Par Value and Principal Cost indicating the gain or loss from the principal of the bonds.

For illustration only. Source: Fidelity.com. For bond ladders, the principal gain/loss is the difference between the Total Par Value and Principal Cost indicating the gain or loss from the principal of the bonds.

Time for the results: The Bond Ladder tool identified 15 bonds that fit Smith’s criteria, with the option to investigate alternatives (not shown here). He chose the number of bonds that would add up to his total investment. The summary shows, among other things, the total cost of purchasing the bonds, their average yield, and how much interest income the ladder is expected to generate in its first year.

For illustration only. Source: Fidelity.com.

This screen shows Smith's expected cash flows over the initial 15-year life of the ladder. His interest income appears to decrease over time, but he may be able to extend that income by reinvesting the returned principal each time one of the bonds matures.

Next steps

If you’re ready to build a bond ladder, consider using the online Fidelity Bond Ladder tool. It walks you step-by-step through the process and helps you to gauge your time horizon, comfort level with risk, and income needs—and identifies choices that fit your criteria from more than 20,000 bonds and CDs.

Important legal information about the e-mail you will be sending. By using this service, you agree to input your real e-mail address and only send it to people you know. It is a violation of law in some jurisdictions to falsely identify yourself in an e-mail. All information you provide will be used by Fidelity solely for the purpose of sending the e-mail on your behalf.The subject line of the e-mail you send will be "Fidelity.com: "

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Before investing in any mutual fund, consider the investment objectives, risks, charges, and expenses. Contact Fidelity for a prospectus or, if available, a summary prospectus containing this information. Read it carefully.

Although bonds generally present less short-term risk and volatility than stocks, the bond market is volatile and investing in bond funds involves interest rate risk; as interest rates rise, bond prices usually fall, and vice versa. This effect is more pronounced for longer-term securities. Unlike individual bonds, most bond funds do not have a maturity date, so avoiding losses caused by price volatility by holding them until maturity is not possible. Bond funds also entail issuer and counterparty credit risk, and the risk of default (the risk that an issuer or counterparty will be unable to make income or principal payments). Additionally, bond funds and short-term investments generally involve greater inflation risk than stocks, since investment returns may not keep up with increases in the prices of goods and services. Any fixed-income security sold or redeemed prior to maturity may be subject to a substantial gain or loss.

In general, the bond market is volatile; bond prices rise when interest rates fall, and vice versa. This effect is usually more pronounced for longer-term securities. Any fixed-income security sold or redeemed prior to maturity may be subject to a substantial gain or loss.

Foreign securities are subject to interest-rate, currency-exchange-rate, economic, and political risks, all of which are magnified in emerging markets. These risks are particularly significant for funds that focus on a single country or region.

*For investments of less than $100,000 ($200,000 when using corporate bond ladders), you may want to consider purchasing bond funds for purposes of diversification.

Fidelity Capital Markets is a division of National Financial Services LLC. National Financial Services LLC is a Delaware limited liability company and registered broker-dealer, and a Fidelity Investments company. Dependable income is subject to the credit risk of the issuer of the bond. If an issuer defaults no future income payments will be made.

A bond ladder, depending on the types and amount of securities within the ladder, may not ensure adequate diversification of your investment portfolio. This potential lack of diversification may result in heightened volatility of the value of your portfolio. You must perform your own evaluation of whether a bond ladder and the securities held within it are consistent with your investment objective, risk tolerance and financial circumstances. To learn more about diversification and its effects on your portfolio, contact a Representative: 1-800-544-6666.

Fidelity Investments does not provide tax or legal advice so you may want to consult an attorney or tax adviser regarding the portfolio bonds you have identified before purchasing your ladder.